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Mark Miller: Remaking Retirement

Seeking Pension Replacement in Retirement

As defined-benefit pensions recede, here are ways investors can build robust guaranteed income streams on their own.

 Ford Motor Company's (F) ads urge you to "swap your ride," but the auto giant also has a swap in mind for 90,000 former employees: a voluntary buyout of their pensions. Ford is offering lump sum payouts to salaried retirees and former workers--a move aimed at cutting pension liabilities and balance sheet volatility.

The huge buyout offer is just the latest sign that defined-benefit pensions are receding as a retirement solution in the private sector. Although DB plans are still pervasive in public-sector workplaces, just 35% of Fortune 1000 companies still sponsor actively accruing plans, according to Towers Watson.

DB pensions and Social Security are the most important sources of guaranteed lifetime income. Both offer critical protection from longevity risk--the chance that you'll outlive your resources in retirement. Last month's column looked at ways to get the most from a pension if you're lucky enough to have one; this month, let's consider options for those who don't. How can you create pensionlike guaranteed income on your own? And what new policies and financial tools are on the horizon that might lead to more low-risk retirement-income options?

Income Annuities
Insurance companies have an important horse in the retirement-income race: the single premium income annuity, or immediate annuity. The proposition is fairly simple: Purchase an annuity that guarantees a specific monthly payment, and the insurance carrier sends you a check each month for the rest of your life.

A SPIA can be used to assure that you'll be able to cover key nondiscretionary expenses, no matter how long you live or how your portfolio fares. Start with a budget projecting monthly costs for shelter, food, utilities, and health care; then subtract Social Security and any other expected guaranteed income payments. The gap figure could be plugged with a SPIA.

A SPIA makes sense only if you're willing to look at it as an insurance product, rather than an investment. You do lose control of your principal, and you can't be sure of a lifetime return because no one knows how long they'll live.

Interest rates also loom large in any consideration of SPIAs. The current ultralow interest-rate environment has depressed what insurance companies can earn on their own portfolios, which cuts into SPIA payouts. But the yield on SPIAs do benefit from the so-called mortality credits baked into annuities. This is a term that refers to the money paid in by customers who die earlier than their life expectancy; that money goes into the overall pool and can be paid out to other annuitants.

SPIAs have played a relatively small role in the overall retirement solutions market, but they've gained some ground lately. Sales rose 6.6% in 2011 to a record $8.1 billion, according to LIMRA, an insurance industry research and consulting group. Some of that gain is the result of marketing partnerships between insurance companies and major workplace-plan providers, such as Fidelity Investments and Vanguard. Insurers also have been ramping up their own independent marketing efforts.

The Obama Administration is hoping to boost interest in annuities and other lifetime-income options through a series of policy proposals unveiled earlier this year. One idea focuses on a little-known type of annuity known as a longevity policy--essentially a deferred annuity that can be bought well ahead of retirement with payouts delayed to an advanced age.

The deferral feature reduces the upfront cost substantially. For example,  Metlife (MET) says that a 65-year-old man could purchase a SPIA generating $1,500 monthly for $269,000, compared with just $52,000 for a longevity policy that starts payouts at age 85.

The Obama plan aims to encourage longevity policy purchases within 401(k) and IRA plans by relaxing the required minimum distribution rules that kick in at age 70 1/2. The proposal would allow savers to exempt the value of their longevity policy from assets used to calculate those mandatory withdrawals.

The risk, of course, is that you don't reach age 85 and never see a dime of your money. But the longevity annuity could allow you to spend down other assets while you're younger, free of worry that you'll come up short at a very advanced age. 

'Buy' More Social Security Income
A delayed Social Security filing is one of the most effective ways to get more annuity-like income in retirement.

You can file for Social Security retirement benefits as early as age 62, but doing so means you'll receive only 75% of your monthly benefit for the rest of your life. On the other hand, waiting until your Full Retirement Age (currently 66) gets you 100% of your earned benefit, and waiting until 70 gets you 132%--nearly double what you'd have received by starting at 62. And any cost-of-living adjustments, or COLAs, awarded during the years you waited are added in when you do file.

That means every year that you delay filing "buys" more inflation-protected monthly annuity income from Social Security down the road. Ideally, you'd do that by working a few years longer, but the math works very well even if it requires spending down some of your nest egg to cover living expenses while you postpone filing for benefits--as illustrated by this hypothetical example (PDF). Waiting until age 66 to take Social Security (Scenario 2 in the example) results in a 36% higher Social Security benefit at age 85 versus starting Social Security at age 62 (Scenario 1). Waiting until age 70 (Scenario 3) results in a nearly 80% higher benefit at age 85. Waiting to take Social Security also means there might be less drag on your retirement accounts in the later years of retirement, which can result in higher account balances, even if you start tapping those accounts before age 66. Click here to download a customizable Microsoft Excel worksheet, where you can input different Social Security primary insurance amounts, living-expense assumptions, retirement account balances, COLAs, and return assumptions in the yellow framed boxes to see the differing impacts on delaying Social Security.

"The long-term benefit of a higher Social Security 'annuity' helps make your savings last longer, even if you are drawing down a larger amount early in your life," says Jim Blankenship, a financial planner in New Berlin, Ill., who prepared the scenarios for Morningstar. Blankenship is the author of A Social Security Owner's Manual: Your Guide to Social Security Retirement, Dependent's, and Survivor's Benefits.

Buying annuity income from Social Security is a better deal than purchasing a commercial income annuity, according to a research brief published this month by the Center for Retirement Research at Boston College. That's partly because of the differences in actuarial approaches, but most importantly, the brief notes, "the additional income available by claiming Social Security later is not affected by current interest rates. The increases in benefits . . . are basic features of the system."

Policy Ideas on the Horizon
Policy experts worry that receding DB pensions will leave a gaping hole in retirement security, and many are beating the drums for new solutions to boost guaranteed income. Along with longevity policies, the recent Obama Administration proposals include several DB pension reforms. One would make it easier for plan sponsors to offer retirees a wider range of choices on how to receive their benefits (lump sum or a stream of monthly payments); another would make it easier for plans to allow employees to buy pension income by investing 401(k) assets into the employer's DB plan.

There's also a movement afoot to use the efficiencies of public-sector DB plans to administer new varieties of pension plans for private-sector workers. The idea is to create DB pension options that would be inexpensive--and simple from an administrative standpoint--even for small companies. Much of the action is taking place in states, rather than at the federal level.

The National Conference on Public Employee Retirement Systems has been lobbying in several states for its Secure Choice Pension. State pension systems would invite employers to set up stand-alone pension plans alongside other employers and the giant state system. Contributions would be made through payroll deductions, and the plans would be managed by a board of public- and private-sector trustees. The pensions would use a cash balance model, where participant benefits would be expressed as a virtual account balance and converted to monthly annuity payments at retirement.

SCP plans would target a 5% rate of return, with a guaranteed floor of 3%. Legislation to create an SCP has been introduced in California, and NCPERS is "in discussion with several other states," according to Hank Kim, the group's executive director.

Kim stresses that participation in the SCP would be optional at several levels. "Employers would have the choice to participate or not, or whether to contribute or simply allow workers to contribute."

New York City is considering a similar idea--but with more mandatory features. New York City Personal Retirement Accounts would allow private-sector workers to enroll in a city-managed pension fund; the concept utilizes the Guaranteed Retirement Account model developed by pension advocate Teresa Ghilarducci, director of the Schwartz Center for Economic Policy Analysis at The New School for Social Research and author of When I'm Sixty-Four: The Plot Against Pensions and the Plan to Save Them.

Under Ghilarducci's plan, employers who don't have an equivalent or better retirement plan where employees or employers together contribute 5% of pay would be required to withhold 5% of pay from employees for their personal retirement account.

Action by a couple of large trend-setting states could get the ball rolling toward activity elsewhere in the country, or even at the federal level, Ghilarducci thinks. "It would change everything," she says. "Major social policy innovation rarely starts at the federal level; it's usually experimentation by the states."

Mark Miller is a retirement columnist and author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work and Living. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

Mark Miller does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.